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CHAPTER2

Basic Managerial Accounting Concepts

This chapter introduces basic terminology that is used throughout the text. Accounting is sometimes called the language of business and learning accounting terminology is similar to learning a foreign language. Understanding the accounting terminology presented in Chapter 2 is crucial to students understanding topics covered later.

LEARNING OBJECTIVES

LO1. Explain the meaning of cost and how costs are assigned to products and services.

  • Cost is the cash or cash-equivalent value sacrificed for goods and services that areexpected to bring a current or future benefit to the organization.
  • Managers use cost information to determine the cost of objects such as products,projects, plants, and customers.
  • Direct costs are traced to cost objects based on cause-and-effect relationships.
  • Indirect (i.e., overhead) costs are allocated to cost objects based on assumed relationshipsand convenience.

LO2. Define the various costs of manufacturing products and providing services as well asthe costs of selling and administration.

  • Products are goods that either are purchased or produced by converting raw materialsthrough the use of labor and indirect manufacturing resources, such as plants, land,and machinery. Services are tasks performed for a customer or activities performed by a customer using an organization’s products or facilities.
  • Product costs are those costs, both direct and indirect, of acquiring a product in amerchandising business and preparing it for sale or of producing a product in a manufacturingbusiness. Product costs are classified as inventory on the balance sheet andthen expensed as cost of goods sold on the income statement when the inventory issold.
  • Selling costs are the costs of marketing and distributing goods and services andadministrative costs are the costs of organizing and running a company.
  • Both selling and administrative costs are period costs.

LO3. Prepare income statements for manufacturing and service organizations.

  • The cost of goods manufactured (COGM) represents the total product cost of goodscompleted during the period and transferred to finished goods inventory. The cost ofgoods sold (COGS) represents the cost of goods that were sold during the periodand, therefore, transferred from finished goods inventory to cost of goods sold. For aretailer, there is no COGM, and COGS equals the beginning inventory plus net purchasesminus ending inventory.
  • For manufacturing and merchandising firms, cost of goods sold is subtracted fromsales revenue to arrive at gross margin. In addition, for manufacturing firms, cost ofgoods manufactured must first be calculated before calculating cost of goods sold.
  • Service firms do not calculate gross margin because they do not purchase or produceinventory for sale and, as a result, do not have a cost of goods sold (i.e., inventoryexpense).
  • All firms next subtract selling and administrative expense to arrive at net income.

Cornerstones

Cornerstone 2.1Calculate Product Cost in Total and Per Unit

Cornerstone 2.2Calculate Prime Cost and Conversion Cost in Total and Per Unit

Cornerstone 2.3Calculate the Cost of Direct Materials Used in Production

Cornerstone 2.4Calculate the Cost of Goods Manufactured

Cornerstone 2.5Calculate the Cost of Goods Sold

Cornerstone 2.6Prepare an Income Statement for a Manufacturing Firm

Cornerstone 2.7Calculate the Percentage of Sales Revenue for Each Line on the Income Statement

Cornerstone 2.8Prepare an Income Statement for a Service Organization

CHAPTER OUTLINE

Discussion Question: After students read the opening “Little Guys Home Electronics,” ask them to select what they considered to be the most important point in the opening scenario.

After students have viewed the video, ask them to answer questions listed within video integration guide at the end of this section.

1.the meaning and uses of cost

One objective of management accounting is to determine the cost of products, services, and customers.

A.Cost

Cost is the cash (or cash equivalent) sacrificed for goods or services that are expected to produce current or future benefits.

Expenses are expired costs.

Accumulating costs is a way that costs are measured and recorded.

A cost object is any item such as products, departments, customers, and activities for which costs are measured and assigned.

B.Tracing Direct Costs

Direct costs can be easily and accurately traced to a cost object. The more costs that can be traced to a cost object, the more accurate are the cost assignments.

Indirect costs cannot be easily and accurately traced to a cost object.

C.Assigning Indirect Costs

Allocation is used to assign indirect costs to a cost object, such as a product or department, using a reasonable and convenient method.

Methods of cost assignment are summarized below:

Description: / identifying and assigning costs to a cost object that
are specifically or physically associated with the cost object
relies on physical observation / assignment of indirect costs to cost objects based on convenience or an assumed linkage
Cost assignment accuracy: / more precise / less accurate

Ethics:Tracking costs can also detect unauthorized activity and possible ethical problems.

D.Other Categories of Cost

Other categories of costs include:

  • Variable cost: a cost that increases in totalas product output increases. For example, the number and cost of bicycle tires will increase as the number of bicycles produced increases.
  • Fixed cost: a cost that does not increase as output increases. For example, the cost of insurance for the factory will not increase as the number of bicycles produced increases, but stays the same.

Discussion Question: Ask students to consider their mobile phone bill. What portion would be considered a variable cost? What portion would be fixed?

Discussion Question: Ask students if they can think of any other examples of variable costs and fixed costs.

Opportunity costs:the benefit given up or sacrificed when one alternative is chosen over another.Opportunity costs are not usually recorded in the accounting system; however, opportunity costs should be considered when evaluating alternatives for decision making.

2.PRODUCT AND SERVICE COSTS

Two types of output of organizations are summarized below:

Definition: / goods produced by converting raw materials using labor and capital (plant, land, and machinery) / (1)activities performed for a customer
or
(2)activity performed by a customer using the organization’s products or facilities
Examples: / laundry detergent
television
bicycles / accounting services
dry cleaning services
video rental
Organization: / Manufacturing organizations produce tangible products. / Service organizations produce intangible products.

A.Determining Product Costs

For external product costing, costs are classified by the function they serve, as summarized below:

Definition: / materials traceable to
goods or services produced
become part of product / labor traceable
to goods or services produced / all product costs other than direct materials and direct labor / costs to market, distribute, and service a product
order-getting and order-filling costs / costs of research, development,
and general administration
Examples: / wood in furniture / chef in restaurant, machine operator on assembly line / supervision, utilities,
indirect materials, indirect labor / advertising, customer service / executive salaries, accounting, research and development

Product costs, for external financial reports, are manufacturing costs (direct materials, direct labor, and manufacturing overhead) that are first added to an inventory account and remain in inventory until sold. The costs are expensed when the product is sold.

Period costs are nonproduction costs (selling and administrative) and are expensed when incurred.

Cornerstone 2.1: How to Calculate Product Cost in Total and Per Unit

The Cornerstones can be implemented in your classes in several different ways:

  1. Demonstrate Cornerstone 2.1 in the Cornerstones text as an example in class.
  2. Use Exercise 2-19 as a demo, in-class exercise. Students can work the exercise individually or in teams.
  3. Discuss the Concept Q&A. Make a list of the costs that you are incurring for your classes this term.Which costs are direct costs for your college courses? Which are indirect costs?
  4. Discuss the Concept Q&A.Focus on any object in the room. What do you think the direct materials for that object might include?What kind of direct labor might have worked on that object? What types of overhead costs might have been incurred by the company that produced it?

B.Prime Costs and Conversion Costs

Prime costs are direct materials costs and direct labor costs.

Conversion costs are the costs of converting raw materials into a final product (direct labor costs and overhead costs).

Cornerstone 2.2: How to Calculate Prime Cost and Conversion Cost in Total and Per Unit

The Cornerstones can be implemented in your classes in several different ways:

  1. Demonstrate Cornerstone 2-2 in the Cornerstones text as an example in class.
  2. Use Exercise 2-20 as a demo, in-class exercise. Students can work the exercise individually or in teams.

C.Period Costs

Period costs are all costs that are not product costs.

1.Selling costs are costs to market, distribute, and service a product or service.

2.Administrative costsare costs associated with research, development, and general

administration of the organization that cannot be assigned to either selling or production.

3.preparing income STATEMENTS

For income statements for external users, the two major functional categories of expenses are:

1.cost of goods sold (production costs), and

2.operating expenses (nonproduction costs).

Production costs (direct materials, direct labor, and overhead) are product costs because these costs attach to the product.

If the product is in inventory, the product cost is reported as inventory on the balance sheet.

If the product has been sold, the product costs are recognized as an expense (cost of goods sold) on the income statement.

Nonproduction costs (selling and administrative costs) are period costs that are expensed each period.

A.Income Statement: Manufacturing Firm

Cost of goods sold consists of the cost of direct materials, direct labor, and overhead attached to the units sold during a period.

The cost of goods manufactured is the cost of direct materials, direct labor, and overhead attached to the units produced during a period.

Work in process consists of all partially completed units in production.

Finished goods are goods that are complete and ready for sale.

Cost flows for a manufacturer are diagramed below:

Cost IncurrenceExpense Category

As direct materials, direct labor, and manufacturing overhead are used in the production process, the associated costs are transferred to the Work-in-Process inventory account.

As the goods in process are completed, the associated costs are transferred to the Finished Goods inventory account.

As the goods are sold, the associated costs are transferred to the Cost of Goods Sold account. Thus, the product costs of direct materials, direct labor, and manufacturing overhead are not expensed until the goods are sold.

Gross margin is the difference between sales revenue and cost of goods sold.

A manufacturing firm might have three inventory accounts on the balance sheet:

1.Raw Materials

2.Work in Process

3.Finished Goods

Cornerstone 2.3: How to Calculate the Direct Materials Used in Production

The Cornerstones can be implemented in your classes in several different ways:

  1. Demonstrate Cornerstone 2.3 in the Cornerstones text as an example in class.
  2. Use Exercise 2-21 as a demo, in-class exercise. Students can work the exercise individually or in teams.

Cornerstone 2.4: How to Calculate Cost of Goods Manufactured

The Cornerstones can be implemented in your classes in several different ways:

  1. Demonstrate Cornerstone 2.4 in the Cornerstones text as an example in class.
  2. Use Exercise 2-22 as a demo, in-class exercise. Students can work the exercise individually or in teams.

Cornerstone 2.5: How to Calculate Cost of Goods Sold

The Cornerstones can be implemented in your classes in several different ways:

  1. Demonstrate Cornerstone 2.5 in the Cornerstones text as an example in class.
  2. Use Exercise 2-23 as a demo, in-class exercise. Students can work the exercise individually or in teams.

Cornerstone 2.6: How to Prepare an Income Statement for a Manufacturing Firm

Cornerstone 2.7: How to Calculate the Percentage of Sales Revenue for Each Line on the Income Statement

The Cornerstones can be implemented in your classes in several different ways:

  1. Demonstrate Cornerstones 2.6 and 2.7 in the Cornerstones text as an example in class.
  2. Use Exercises 2-24 and 2-25 as demo, in-class exercises. Students can work the exercises individually or in teams.

B.Income Statement: Service Organization

Cost flows for a service firm are diagramed below:

Cost IncurrenceExpense Category

Cornerstone 2.8: How to Prepare an Income Statement for a Service Organization

The Cornerstones can be implemented in your classes in several different ways:

  1. Use Cornerstone 2.8 in the Cornerstones text as an example in class.
  2. Use Problem 2-26 as a demo, in-class problem. Students can work the problem individually or in teams.

APPLICATIONS

Applications for the chapter include the following:

A.In-class Group Practice Tests. See the end-of-chapter multiple-choice questions provided in the text for an in-class, group test or for use with a personal response system. With a group test, each student takes the quiz or test individually. Then ask students to break into teams of four or five to grade the test and discuss answers.

B.Video Integration. See the guide at the end of this chapter for a description of video and additional discussion questions and demonstration problems.

Video integration guide

Video Case:Experience Accounting with The Little Guys:Priced to Sell

Video Running Time:6:10 minutes

Organization Discussed:Little Guys Electronics

Video Case Learning Goals
  • Explains how a home electronic retail store, a service organization, uses cost-plus pricing and excellent customer service in the competitive electronics market
  • Provides examples of overhead costs and labor; and explains their effects on the price of products
  • Discusses competitive pricing strategies and how prices relate to manufacturer’s prices
  • Explains different prices (dealer cost, retail price, list price) its costs relating to purchasing electronic products and deduct from invoice (DFI) discounts

Chapter Concepts Spotlighted in Video

  • Cost
  • Expenses
  • Manufacturer
  • Margin
  • Markup
  • Overhead
  • Price
  • Profit
  • Sale
  • Service organization
  • Services
  • Value-added

Video Case Synopsis

The video describes how the Little Guys, a South Chicago home electronic retail store, determines its prices to maintain competitive with major retailers such as Best Buy.Company employees explain how (1) the organization uses cost-plus pricing, (2) implements other competitive pricing strategies, and (3) overhead (delivery trucks, gas, insurance, insurance, heat, electricity, and warehousing), and (4) labor (installation crew) costs affect the price of products. This company remains competitive with large discount retailers such as Best Buy, Circuit City, Walmart, and Target through its fair prices and excellent service. Their emphasis on customer service and installation of products achieves success and generates profits.

Video Case Discussion Questions and Suggested Answers
  1. Explain the difference between a service organization and a manufacturing organization.How does the income statement differ?

The Little Guys is a service organization that purchases its electronic products from a manufacturing organization.An income statement for a service organization includes the cost of services sold: electronic products (materials), installation costs (labor), and overhead.A manufacturing income statement includes the cost of goods manufactured that represents costs assigned to completed goods—direct material, direct labor, and overhead.

  1. Give examples of overhead that The Little Guys incurs.

Costs associated with the deliver trucks (gas, insurance), selling expenses relating to its stores (insurance, heat, electricity), warehousing expenses

  1. Provide examples of period costs and product costs.When are these items reported on the income statement?

The cost of its inventory (Invoice price less DFI) are product costs.The overhead costs associated with the deliver trucks (gas, insurance), selling expenses relating to its stores (insurance, heat, electricity), warehousing expenses are examples of period costs. Period costs are expensed immediately whereas product costs are expensed when the goods are sold.

  1. Does The Little Guys sell tangible or intangible products?

Both are sold.The electronic goods are an example of tangible products whereas the installation services are an example of intangible products.

  1. Go to: and find the current sales prices of electronic products.

Answers will vary depending on posting on the website.As of November 1, 2006, an Apple Ipod was on sale for $199.

  1. Assume that The Little Guys sold 500 Ipods at $200 each.If they had paid $160 for each Ipod, what is their gross margin on each Ipod and what is the total gross margin?What is their mark-up percentage.

Sale price $200 less $160 is equal to $40 margin Mark-up is 25% (160/40).The total gross margin is $20,000 ($40 each times 500 OR Total sales of $100,000 less cost of goods sold of $80,000.

Follow-up Experiential Exercises

1. Obtain published financial statements of a manufacturing and a service organization.Compare and contrast their income statements and balance sheets.Provide examples of product costs and period costs.

2. Obtain published financial statements of two manufacturing companies within the same industry. Compare and contrast their income statements and balance sheets. How does the cost of goods sold vary for the two companies?What are the gross margin percentages for the companies? How would manufacturing companies determine the price to charge their customers? How does this compare to a service organization? Provide examples of product costs and period costs?

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